Interest Rates, Capital and Bank Risk-Taking

44 Pages Posted: 21 Dec 2018

Date Written: December 21, 2018

Abstract

Are low interest rates more likely to incentivise greater bank risk-taking? This is the question we seek to answer. Using a model in which banks raise funds from depositors to create an investment portfolio which can differ in its risk and return, we suggest so. In particular, we show that lowering the interest rate makes it more likely banks will make risky investments. This is because reducing the interest rate makes safer assets less attractive, while increasing the relative gains from gambling. We show that risk-taking is highly dependent on banks’ skin-in-the-game, as banks always ignore the full extent of losses on bankruptcy. Raising the interest rate has a similar effect. It reinforces this behaviour, as by increasing the yield on the portfolio, banks have more to lose on bankruptcy.

Keywords: Banking, monetary policy, risk-taking, interest rates

JEL Classification: E44, E58, G21

Suggested Citation

Acosta Smith, Jonathan, Interest Rates, Capital and Bank Risk-Taking (December 21, 2018). Bank of England Working Paper No. 744. Available at SSRN: https://ssrn.com/abstract=3305216 or http://dx.doi.org/10.2139/ssrn.3305216

Jonathan Acosta Smith (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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